Republican GOP Tax Bill Introduces Major Reforms To The Taxation Of U.S. Corporations Engaged In Business Operations Overseas: Introduction Of The Participation Exemption

By: Jerald David August

Overview of Need for Reform of Income Taxation of U.S. Corporations With Respect to Foreign Subsidiaries

As promised from various talks and presentations leading up to the introduction of H.R. 1, 115TH Cong., 1st Sess., the Tax Cuts and Jobs Act, as well as the recent Republican Unified Framework for Tax Reform, released September 27, 2017, the GOP Bill introduces major reforms to the international taxation of U.S. businesses, particularly U.S. corporations owning 10% or more of the stock of a foreign corporation. The changes are wide-sweeping and perhaps controversial and marks a paradigm shift in moving the taxation of U.S. corporations from a worldwide income system, with allowance for claiming deemed foreign tax credits on dividends received from such foreign corporations, to a territorial based, participation exemption system which is utilized by many foreign countries.

For months now the Republican Party as well as President Trump have noted the lack of a level playing field for U.S. companies doing business overseas. While this perceived lack of competitiveness has inspired inversions and base erosion strategies, the alleged source of this lock-out of overseas profits is our worldwide system of taxation. Proponents for a territorial based system of corporation taxation have long held the view that the United States taxes foreign earned income of U.S. companies in a manner which is inefficient, complex and results in a competitive disadvantage as compared with companies resident and doing business in other OECD countries. In contrast to a territorial system of taxation, the worldwide system used in the United States allows for the deferral of U.S. tax on much foreign earned income, e.g., non-Subpart F income of a controlled foreign corporation or simply income of a non-controlled foreign based company, which allows for a foreign tax credit as repatriating dividends are made against the high U.S. corporate income tax rate.

More specifically, U.S. companies have long been placed in a competitive disadvantage by competing with foreign companies that have been taxed for years are significantly lower rates on their domestic source income, been subject to a territorial instead of a worldwide tax system of taxation, and have been able to avoid tax on repatriated earnings of foreign source dividends not subject to home country taxation under a participation exemption. For U.S. corporations, the high domestic income tax rate and the benefits of tax deferral or possibly little if any foreign taxes paid on foreign source income through ownership of a foreign based subsidiary, perhaps with a management base in a tax have,  has resulted in trillions of dollars of non-repatriated profits owned or controlled by U.S. companies. 

Specific Measures in H.R. 1 Designed to Restore U.S. Corporate Competitiveness in the Global Economy

The Tax Cuts and Jobs Act addresses this problem area in by: (i) reducing the U.S. corporate tax rate to a flat 20%; (ii) allowing foreign accumulated earnings and profits to be repatriated in cash or cash equivalent at a 12% rate,  with the repatriation of non-cash assets subject to U.S. corporate income tax at a rate of  5%, payable over up to 8 years if the taxpayer so elects; and (iii) establishing a participation exemption system on foreign earnings with respect to 10% or more owned foreign subsidiaries when such earnings are distributed back to the U.S. 

Introduction of the New Participation-Exemption System

This new participation exemption system would replace the long-standing dividend-exemption system. Under the participation exemption system, 100% of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the stock of the foreign corporation would be exempt from U.S. tax. No foreign tax credit or deduction would be allowed for any foreign taxes including withholding taxes that are paid or accrued with respect to any exempt dividend. No deduction for expenses properly allocable to an exempt dividend or stock that gives rise to exempt dividends would be taken into account in determining the corporate shareholders’ foreign source income.

The rationale for this dramatic change in the taxation of U.S. corporation doing business overseas is to remove or eliminate the “lock-out” effect under current law which encourages U.S. companies to avoid repatriating their foreign earnings back into the U.S. and thereby avoid U.S. residual taxation on such earnings, especially where the dividends exceed the foreign corporation’s accumulated earnings and profits.

In order to prevent the new participation-exemption system from being employed in an exploitative manner, an anti-base erosion feature is contained in the GOP Bill that would subject to income tax 50% of a U.S. parent corporation’s foreign “high returns”. For this purpose, “high returns” means the excess of the parent’s foreign subsidiaries’ aggregate net income over the “routine return” on the foreign subsidiaries’ aggregate adjusted basis in depreciable tangible property less interest expense. Routine return is 7% plus the federal short-term rate. Foreign high returns would be allowed 80% of relevant foreign tax credits, which could not be carried forward or back. Obviously the actual statutory language is complex.

There are other important provisions contained in the GOP Bill which make corresponding changes in the rules applicable to basis in stock of a foreign corporation, the foreign tax credit rules, the treatment of deferred foreign income in transitioning to a participation exemption system of taxation, modifications of the Subpart F rules, and base-erosion rules.

GOP Bill, Section 4001, Taxation of Foreign Income and Foreign Persons. As promised, the GOP Bill makes major reforms to the international taxation of U.S. businesses, particularly U.S. corporations owning 10% or more of the stock of a foreign corporation. The changes are wide-sweeping and profound an moves the taxation of U.S. corporations from a worldwide income system, with allowance for claiming deemed foreign tax credits on dividends received from such foreign corporations to a territorial based, participation exemption system which is utilized by many foreign countries. What is the source of the problem has been the lower tax rates offered overseas on foreign source business income as well as the participation exemption provided on foreign source dividends. For U.S. corporations, the high domestic income tax rate and the benefits of tax deferral or possible no or little tax paid on foreign source income through ownership of a foreign based subsidiary has let to trillions of dollars of non-repatriated profits.

The Tax Cuts and Jobs Act addresses this problem area in by: (i) reducing the U.S. corporate tax rate to a flat 20%; (ii) allowing the repatriation of foreign accumulated earnings and profits to be repatriated in cash or cash equivalent at a 12% rate, with noncash assets would be taxed at 5%, payable over up to 8 years if the taxpayer so elects; and (iii) establishing a participation exemption system on foreign earnings of their foreign subsidiaries when such earnings are distribution. This new participation exemption system would replace the long-standing dividend-exemption system.

Under the participation exemption system, 100% of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the stock of the foreign corporation would be exempt from U.S. tax. No foreign tax credit or deduction would be allowed for any foreign taxes, including withholding taxes that are paid or accrued with respect to any exempt dividend. No deduction for expenses properly allocable to an exempt dividend or stock that gives rise to exempt dividends would be taken into account in determining the corporate shareholders’ foreign source income. The rationale for this dramatic change in the taxation of U.S. corporation doing business overseas is stated to remove or eliminate the “lock-out” effect under current law which encourages U.S. companies to avoid repatriating their foreign earnings back into the U.S. to avoid U.S. residual taxation on such earnings, especially where the dividends exceed the foreign corporation’s accumulated earnings and profits.

 On the other hand, an anti-base erosion feature is set forth in the GOP Bill that would subject to tax 50% of a U.S. parent corporation’s foreign “high returns”. For this purpose, “high returns” would be the excess of the parent’s foreign subsidiaries’ aggregate net income over the “routine return” on the foreign subsidiaries aggregate adjusted basis in depreciable tangible property less interest expense. Routine return is 7% plus the federal short-term rate. Foreign high returns would be allowed 80% of relevant foreign tax credits, which could not be carried forward or back.

There are other important provisions contained in the GOP Bill which make corresponding changes in the rules applicable to basis in stock of a foreign corporation, the foreign tax credit rules, the treatment of deferred foreign income in transitioning to a participation exemption system of taxation, modifications of the Subpart F rules, and base-erosion rules, as mentioned.

Summary of Important Proposed International Tax Rules Contained in H.R. 1.

GOP Bill, Section 4001. Deduction For Foreign-Source Portion of Dividends Received by Domestic Corporations From Certain Ten Percent Owned Foreign Corporations.  The Subtitle A to the Bill is the “Establishment of Participation Exemption system for Taxation of Foreign Income”.  This provision would replace the deemed foreign tax credit approach to worldwide taxation of U.S. corporations, by replacing such system with a dividend-exemption system. Under the exemption system, 100% of the foreign-source portion of dividends paid by a foreign corporation (FC) to a U.S. corporate shareholder that owns 10% or more of the FC would be exempt from U.S. taxation. No foreign tax credit (FTC) or deduction would be allowed for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend, and no deductions for expenses properly allocable to an exempt dividend (or stock that gives rise to exempt dividends) would be taken into account for purposes of determining the U.S. corporate shareholder’s foreign-source income.

GOP Bill, Section 4002. Application of Participation Exemption to Investments in U.S. Property.  Generally, a U.S. corporation owning 10% or more of the stock in a FC generally is not subject to U.S. tax, as mentioned, on the earnings of the foreign subsidiary until the earnings are distributed to the U.S. parent corporation. The foreign subsidiary’s undistributed earnings reinvested in U.S. property are subject to income tax in the U.S. for this purpose, U.S. property includes tangible property located in the U.S., intangible property used in the U.S., and equity and debt interests issued by U.S. affiliates. Accordingly, a U.S. corporate shareholder cannot avoid U.S. tax on the distribution of earnings from a foreign subsidiary by reinvesting the foreign earnings in U.S. property.

Under the GOP Bill, the imposition of current U.S. tax on U.S. corporate shareholders with respect to untaxed foreign subsidiary earnings reinvested in United States property would be repealed.

GOP Bill, Section 4003. Limitation on Losses With Respect to Specified Ten Percent Owned Foreign Corporations.  Under the participation-exemption system for taxation of foreign income, a U.S. parent would reduce the basis of its stock in a foreign subsidiary by the amount of any exempt dividends received by the U.S. parent from its foreign subsidiary - but only for purposes of determining the amount of a loss (but not the amount of any gain) on any sale or exchange of the foreign subsidiary stock by its U.S. parent. Where a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign subsidiary, the U.S. corporation must include in income the amount of post-2017 (year of enactment) losses realized by the branch.

GOP Bill, Section 4004. Treatment of Deferred Foreign Income upon Transition to Participation Exemption System of Taxation.  U.S. shareholders owning 10% or more of a FC generally will be required to include in income for the FC’s last tax year beginning before 2018 (year of enactment), the shareholder’s pro rata share of the net post-1986 historical earnings and profits (E&P) of the FC to the extent such E&P has not been previously subject to U.S. tax as of a stated date. The net E&P is determined by taking into account the U.S. shareholder’s proportionate share of any E&P deficits of FCs of the U.S. shareholder or members of the U.S. shareholder’s affiliated group. The E&P would be characterized as either E&P that has been retained in the form of cash or cash equivalents, or E&P that has been reinvested in the foreign subsidiary’s business (e.g. property, plant, and equipment). The portion of the E&P comprising cash or cash equivalents would be taxed at a reduced rate of 12%, while any remaining E&P would be taxed at a reduced rate of 5%.  FTC carryforwards would be fully available and FTCs resulting from the deemed repatriation would be available in part in reducing the U.S. tax. At the election of the U.S. shareholder, the tax liability would be payable over a period of up to 8 years, in equal annual installments 12.5% of the total tax liability due. If the U.S. shareholder is an S corporation, the  E& P purging-type provision would not apply until the S corporation ceases to be an S corporation, substantially all of the assets of the S corporation are sold or liquidated, the S corporation ceases to exist or conduct business, or stock in the S corporation is transferred. ·

GOP Bill, Section 4101. Repeal of the Section 902 Indirect Foreign Tax Credits; Determination of Section 960 Credit on Current Year Basis.  At present, foreign income earned by a foreign subsidiary of a U.S. corporation generally is not subject to U.S. tax until the income is distributed as a dividend is allowed a deduction or credit for the foreign tax paid on the dividend (or deemed reinvestment in the U.S.) under the deemed payment, gross-up rules under sections 902,  960 and 78. The foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed on foreign-source income. Under certain circumstances, the U.S. parent corporation is subject to current U.S. income tax on certain foreign income of its foreign subsidiaries (“subpart F income”) even if the income is not repatriated. A U.S. parent corporation generally may claim a credit for foreign taxes paid on the subpart F income.  Under the GOP bill, under the new participation-exemption system no foreign tax credit or deduction is allowed for foreign taxes (including withholding taxes) paid or accrued with respect to any dividend to which the dividend exemption under section 4001 of the bill would apply. A FTC would be allowed for any subpart F income that is included in the income of the U.S. shareholder on a current year basis, without regard to pools of foreign earnings kept abroad.

GOP Bill, Section 4102. Source of Income from Sales of Inventory Determined Solely on Basis of Production Activities.  Present law permits in determining the source of income for FTC purposes, up to 50% of the income from the sale of inventory property produced within the U.S. and sold outside the U.S. (or vice-versa) may be treated as foreign-source income, even though the production activity takes place entirely within the U.S.  Under the GOP Bill, income from the sale of inventory produced within and sold outside of the U.S. (or vice-versa) would be allocated and apportioned between sources solely on the basis of the production activities as to the inventory.

GOP Bill, Section 4204, Look-Thru Rule for Related Controlled Foreign Corporations Made Permanent. Under present law, a U.S. parent of a foreign subsidiary generally is subject to current U.S. income taxation on dividends, interest, royalties, rents, and other types of passive income earned by the foreign subsidiary, regardless of whether the foreign subsidiary distributes such income to the U.S. parent. However, for tax years of foreign subsidiaries beginning before 2020, and tax years of U.S. shareholders in which or with which such tax years of the foreign subsidiary end, a special “look-through” rule provides that passive income received by one foreign subsidiary from a related foreign subsidiary generally is not includible in the taxable income of the U.S. parent, provided such income was not subject to current U.S. tax or effectively connected with a U.S. trade or business. Under the GOP Bill, the look-through rule would be made permanent as of a stated effective date.

GOP Bill, Sections 4205 and 4206: Modification of Stock Attribution Rules for Determining Status As a Controlled Foreign Corporation (CFC) and Elimination of 30 Day Ownership Provision.  A U.S. parent shareholder of a CFC is subject to current U.S. income taxation with respect to its pro rata share of the CFC’s subpart F income.  A foreign subsidiary is a CFC if it is more than 50% owned by one or more U.S. persons, each of which owns at least 10% of the foreign subsidiary. For these purposes, a U.S. person may be treated as constructively owning stock held by certain related persons, affiliates, and shareholders, but a U.S. corporation generally cannot be treated as constructively owning stock held by its foreign shareholder. Under the GOP Bill, a U.S. corporation would be treated as constructively owning stock held by its foreign shareholder. 

Another rule under current law is that the CFC rules apply only if the U.S. parent (shareholder) owns stock in the FC for an uninterrupted period of 30 days or more during the year. Under the GOP Bill, a U.S. parent would be subject to current U.S. tax on the CFC’s subpart F income even if the U.S. parent does not own stock in the CFC for an uninterrupted period of 30 days or more during the year.

GOP Bill, Section 4301, Current Year Inclusion by U.S. Shareholders with Foreign High Returns.  An important base-erosion provision adopted with the participation-exemption system, is section 4301 of the Bill which provides that a U.S. parent of one or more foreign subsidiaries would be subject to current U.S. income taxation on 50% of the U.S. parent’s foreign high returns. Foreign high returns would be measured as the excess of the U.S. parent’s foreign subsidiaries’ aggregate net income over a routine return (7% plus the Federal short-term rate) on the foreign subsidiaries’ aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include income effectively connected with a U.S. trade or business, subpart F income, insurance and financing income that meets the requirements for the active finance exemption (AFE) from subpart F income under current law, income from the disposition of commodities produced or extracted by the taxpayer, or certain related-party payments.  In similar manner with subpart F income, the U.S. parent would be taxed on foreign high returns each year, regardless of whether it left those earnings offshore or repatriated the earnings to the United States.

GOP Bill, Section 4302. Limitation on Deduction of Interest by Domestic Corporations Which Are Members of an International Financial Reporting Group.  While reducing the corporate tax rate under the GOP Bill may reduce the influence of debt, the Bill still provides rules to discourage excessive debt. This provision is designed to prevent multinational companies from generating excessive interest deductions in the United States on debt that is issued to foreign affiliates or that is incurred to produce exempt foreign income in a dividend-exemption system.

Under section 4302 of the Bill, the deductible net interest expense of a U.S. corporation that is a member of an international financial reporting group is  limited to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110% of the U.S. corporation’s share of the group’s global earnings before interest, taxes, depreciation, and amortization (EBITDA). This limitation would apply in addition to the general rules for disallowance of certain interest· expense under section 3301 of the Bill. Taxpayers would be disallowed interest deductions pursuant to whichever provision denies a greater amount of interest deductions. Any disallowed interest expense would be carried forward for up to five tax years, with carryforwards exhausted on a first in, first out basis. For this purpose, an international financial reporting group is a group of entities that includes at least one foreign corporation engaged in a trade or business in the United States or at least one domestic corporation and one foreign corporation, prepares consolidated financial statements, and has annual global gross receipts of more than $100 million.

GOP Bill, Section 4303, Excise Tax on Certain Payments From Domestic Corporations To Related Foreign Corporations; Election to Treat Such Payments As Effectively Connected Income. The Summary acknowledges that under present law, multinational enterprises, and particularly foreign-parented multinational enterprises, can erode the U.S. tax base by shifting profits to foreign affiliates, based on risk shifting, asset deployment and functions taking place outside of the U.S. The foreign profits of such foreign affiliates generally will avoid U.S. income tax thus giving foreign companies a  significant tax advantage over U.S. companies for sales to U.S. customers and provides significant tax incentives for U.S. companies to either invert or be acquired by foreign companies. Current law therefore affords significant opportunities to multinational companies to erode the U.S. tax base through deductible related-party payments. Although these payments frequently relate to globalized supply chains.

Under the GOP Bill, payments (other than interest) by a U.S. corporation to a related FC that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset would be subject to a 20% excise tax, unless the related FC elected to treat the payments as income effectively connected with the conduct of a U.S. trade or business. Consequently, the foreign corporation’s net profits (or gross receipts if no election is made) with respect to those payments would be subject to full U.S. tax, eliminating the potential. U.S. tax benefit otherwise desired, i.e., reduction in U.S. taxable income.

Exceptions would apply for intercompany services which a U.S. company elects to pay for at cost (i.e., no markup) and certain commodities transactions. To determine the net taxable income that is to be deemed ECI, the foreign corporation’s deductions attributable to these payments would be determined by reference to the profit margins reported on the group’s consolidated financial statements for the relevant product line. No credit would be allowed for foreign taxes paid with respect to the profits subject to U.S. tax. Further, in the event no election is made, no deduction would be allowed for the U.S. corporation’s excise tax liability. The provision would apply only to international financial reporting groups with payments from U.S. corporations to their foreign affiliates totaling at least $100 million annually.

GOP Bill, Section 4502. Limitation on Treaty Benefits for Certain Deductible Payments With Respect to Fixed and Determinable, Annual or Periodical (FDAP) Income. Under the Bill, if a payment of FDAP income is deductible in the United States and the payment is made by an entity that is controlled by a foreign parent to another entity in a tax treaty jurisdiction that is controlled by the same foreign parent, then the statutory 30% withholding tax on such income would not be reduced by any treaty unless the withholding tax would be reduced by a treaty if the payment were made directly to the foreign parent.


"Disclaimer of Use and Reliance: The information contained in this blog is intended solely for informational purposes and the benefit of the readers of this blog. Accordingly, the information does not constitute the rendering of legal advice and may not be relied upon by the reader in addressing or otherwise taking a position on one or more specific tax issues or related legal matter for his or her own benefit or for the benefit of a client or other person.” ©Jerald David August for Kostelanetz & Fink, LLP”